HapiMoney

Everyone knows that you should invest your money in the stock market, but not a lot of newbies understand a lot of the rationale.  Thus, here’s a little investing 101 seminar.

Risk/Reward

To simplify, the riskier something is, the better the payout should be. For instance, winning the lottery is such a low probability event that the payout has to be huge in order for people to play. If the payout were only a few dollars but the chance of winning was still a million to one, nobody would play (or rather, nobody should play).

In terms of investing, this is also a true. The cash you have in your bank account is basically as risk free as you can get…which is also why it pays so little in interest. CD’s are a little riskier, so they pay better, bond’s are even riskier, and stocks are the riskiest (non-publicly traded stock being the most risky of all).

You can actually see this represented in what’s called a “yield curve“. Click here to see the latest rates on bonds of different maturities (or in other words, how long they take to pay off).

Returns

If you clicked on that link, you would see that if you were to invest all of your money into 30 year government bonds, then you would earn about 5% in interest every year.  That’s not too shabby. So what about stocks?

Well, it’s a little bit more complicated because stocks don’t all pay interest like bonds do (though many pay dividends). Rather, we have to calculate how much the price of the stock goes up in order to see what the equivalent “yield” is.  If you look back historically, from 1900 through 2008,  the S&P returned about 9.5% annually (this is compounded, not a simple average).  Thus, stocks over the last century performed about twice as well per year than long term bonds. To play around with this yourself, click here.

So why wouldn’t everyone invest everything into stocks? Because of the enormous swings. In 2008, the market lost almost 40% of it’s value – so you’re $10,000 investment would be worth $6,000 in the course of a few months. In 2002,  it lost about 20%. And in the years 1929, 1930, 1931 and 1932 it lost 10%, 23%, 44% and 6% respectively. Over the short term, bad bad things can happen.

So what do I do?

When investing, plan for the long term. Understand that if you are in the game long enough, eventually stocks will rebound and provide you with solid returns, but it will take time. If you need money in the short term, invest in things that are safer like bonds.  And ideally, construct a combination of stocks and bonds that will provide for large enough returns while also providing relative safety.